(_e_) _Management and Control._ No question is of greater importance in estimating the strength of an industrial company than the reputation of the men in charge. The ability and integrity of the men who control the policy of the company and the efficiency of the operating officials are the princ.i.p.al factors in the success of an industrial undertaking.

Vacillating policies, weakly executed, will ruin the most promising enterprise. This is particularly true in the case of small companies.

Every man of business experience will understand the importance of this factor and be guided by it in the selection of industrial securities.

Based upon the foregoing considerations it is of interest to inquire what degree of safety really attaches to the average industrial bond?

How far does it meet the foregoing requirements? The question is difficult to answer. Industrial bonds vary greatly in point of safety, some issues possessing great strength and others being highly speculative. No general conclusions can be depended upon, and the investor is forced to consider each issue upon its own merits.

II. _Rate of Income._ The average net return upon industrial bonds is probably higher than upon any other form of funded corporate obligation.

This const.i.tutes one of the chief advantages of industrial bonds.

III. _Convertibility._ It is impossible to make any general statement in regard to the convertibility of industrial bonds. Some industrial bonds, notably the larger issues of well-known trusts, command a broad and active market. Such bonds can be sold in large amounts at almost any time without seriously affecting the price. On the other hand, small underlying issues of such companies, usually high-grade in point of security, or the obligations of smaller companies, are almost as unmarketable as real-estate mortgages. Between these two extremes all varieties of industrial bonds are to be found. The degree of convertibility which a security possesses is usually a matter of some importance, and the investor should make a careful examination of each bond in this respect.

IV. _Prospect of Appreciation in Value._ To what extent a bond may improve in security during the time that an investor holds it is of little importance unless the improvement be reflected in the market price of the bond. Only so can the investor take advantage of its appreciation in value. In order for the improvement in security to be reflected in market price and thus add to the princ.i.p.al invested, it is necessary that a bond should possess a fairly active market. For this reason the industrial bonds which hold out the greatest promise of appreciation in value are the larger, more speculative issues, which possess the greatest convertibility. The purchase of such bonds frequently results in substantial profits.

V. _Stability of Market Price._ The four points above touched upon--safety, rate of income, convertibility, and likelihood of improvement in intrinsic value--are all inherent characteristics of every bond. The likelihood of favorable or unfavorable fluctation in market price is largely external in its nature and depends upon general financial and business conditions.

As a cla.s.s, industrial bonds can not be said to possess much stability of market price. Some of the smaller issues enjoy a fict.i.tious stability because of their inactivity, but generally speaking industrial bonds are subject to wide fluctations in accordance with changes in the business outlook.

The foregoing is a summary, necessarily brief and imperfect, of the main points to be considered in judging the value of industrial bonds. The question remains whether such securities are desirable for the investment of a business surplus and of private funds.

Except in special cases industrial bonds are not suitable for a business surplus. It is impossible to find an industrial bond which combines all the characteristics necessary for that purpose. The requirements are great safety of princ.i.p.al and interest, a relatively high return, ready convertibility, and stability of market price. Many industrial bonds can be found which combine two of these requirements, some even which combine three, but the full combination, if it exists at all, is unknown to the writer.

In addition, the principle of distribution of risk should prevent one industrial company from investing its reserve funds in the securities of another industrial company.

For private investment the case is somewhat different. A man of good business judgment, who desires to obtain a high yield for which he is prepared to sacrifice something in the way of convertibility and prospect of appreciation in value, may buy the underlying issues of strong companies with every confidence in the safety of his princ.i.p.al.

Again, the investor who wants a high yield and quick convertibility, who is prepared to take a business man's risk and to sacrifice stability of market price, may make a large profit by buying second-grade industrial bonds. No investor, however, should deceive himself with the idea that any industrial bond will satisfy all the requirements of the ideal investment.

VI

PUBLIC-UTILITY BONDS

It was a common saying among bond-dealers a few years ago that the day of the munic.i.p.al bond had pa.s.sed, the day of the railroad bond was pa.s.sing, and the day of the public-utility bond was to be. Munic.i.p.al bonds were selling at fancy prices in consequence of the low rates for money which then prevailed, and railroad bonds appeared to be following in their wake. Public-utility bonds alone afforded a satisfactory yield, and it was felt that the investing public would be forced to turn to them.

This prediction, like many others which were based upon the a.s.sumption of continued ease in money, was destined to be unfulfilled. Almost immediately there appeared an added demand for capital, and in the face of this demand, supplies of capital which had before seemed ample became suddenly scarce. Money rates rose rapidly and as a necessary consequence munic.i.p.al and railroad bonds fell in price to a point where their net return was commensurate with that obtained from the loaning of free capital. The investment situation was thus completely reversed. It was no longer a question as to what form of security investors must seek in order to obtain a satisfactory yield, but rather could the highest grade of munic.i.p.al and railroad bonds be floated at any price. Under these circ.u.mstances the contemplated necessity of turning to public-utility bonds never arose, and the general investing public remains for the most part unfamiliar with their elements of strength and of weakness.

The term "public-utility company" denotes a private corporation supplying public needs under authority of a public franchise. The franchise may be of definite date or perpetual, and may be partial or exclusive.

Public-utility companies include street-railway, gas, electric-light and power, and water companies. Properly speaking, telephone companies should also be included, but they are not usually regarded as belonging to the cla.s.s of public-service corporations.

It is impossible, within the limits of a single chapter, to discuss each kind of company separately. The investment value of street-railway bonds will be here considered, and it is felt that the general principles advanced, with slight modifications of detail, will be found equally applicable to a judgment of other forms of public-service securities.

I. _Safety of Princ.i.p.al and Interest._ In order to determine the safety of a street-railway company's bonds, the company must be subjected to a threefold examination, physical, financial, and political.

An examination must be made into the extent and condition of the physical property in order to ascertain whether the bonded debt is secured by property having a real market value in excess of the face amount of bonds issued. The first point to be determined is the extent and valuation of the company's real estate. If the appraised value of the land upon which power-houses and car-barns have been erected is alone greater than the amount of bonds outstanding, the investigation need go no further, for the bonds, in such a case, would be practically a real-estate mortgage. In most instances, however, this is very far from being the case; and after careful appraisal of the real estate it is then necessary to make a careful valuation of the other physical property; namely, power-plants, depots, car-sheds, roadway, and equipment.

It is usually impossible for the average investor to make such an examination himself, nor is it likely that he would possess sufficient technical knowledge to render his investigation of much value. For an accurate estimate of the value of a street-railway's physical property, it is usually necessary to depend upon the expert opinion of a trained engineer. It is a matter of regret that the average street-railway report can not be relied upon to furnish an accurate valuation of the physical property; and it is accordingly customary for careful bond-dealers, when they contemplate taking an issue of street-railway bonds for distribution among their clients, to have the property examined by a competent engineer, whose report then determines for them the question of taking the issue.

Disregarding the figures which show the cost of property and equipment upon the company's books, the engineer proceeds to make a careful estimate of the replacement value of the property, including real estate. If the result of the examination shows that the property could not be duplicated for the amount of the bond issue, the company occupies an unusually strong position--altho even in such a case some part of the value of the bonds comes from the strength of the company as a going concern.

In most cases, however, it is probably found that the bond issue is in excess of the value of real estate and the replacement value of the physical property, the balance representing a capitalization of the franchise.

To determine the real value of the franchise or franchises is a difficult matter and involves the whole question of the company's relations with the community which it serves and with the local lawmaking bodies.

The first question which arises is whether the franchise is perpetual or for a definite time, and the second whether it is partial or exclusive.

Franchises vary greatly in these respects. Sometimes a franchise, apparently partial, is practically exclusive, owing to the fact that all the available s.p.a.ce in the streets is already occupied by the company's own tracks. If the franchises of a company are limited as to time, it is expedient, if not imperative, that the bonds should mature before the expiration of the franchises.

If the company whose bonds are under examination satisfactorily pa.s.ses this physical test--if it possesses real estate of considerable value, if the replacement value of the property is as great or nearly as great as the amount of the bonds, and if the franchises, while perhaps not perpetual or exclusive, are yet of longer duration than the bonds and render successful compet.i.tion unlikely--the next step may then be taken; that is to say, an examination of the company's financial condition and earning capacity may be made.

The amount of its gross earnings should be examined and the figures scrutinized for a number of years back to discover whether its earnings are increasing or decreasing. The position in which the company stands for obtaining new traffic must be noted, and some estimate must be made of the stability of its earning power. In this connection the relations of the company to the public are of great importance. It must be learned whether the company follows the policy of conciliating or ignoring public sentiment.

The net earnings of the company must then be examined. This involves a criticism of operating expenses. The payments of the road must be a.n.a.lyzed to determine whether the proper amounts have been expended for renewal of track, replenishment of rolling stock, and other improvement sufficient to keep the property in good physical condition. This is the most intricate subject in the investigation of a street-railway property. Unless proper allowance be made for depreciation, in addition to the expenses of direct operation, it is only a question of time before the strongest company will become bankrupt.

Deterioration of plant and equipment, which goes on constantly, can only be offset in two ways: one is out of earnings and the other is out of the security-holders--that is, by decreases in the market value of the securities. The first takes prosperity or courage; the second leads to bankruptcy. It is difficult to measure depreciation accurately, but a safe rule is to write off ten per cent of gross earnings each month for depreciation. In this way the charge for depreciation will be proportionate to the traffic, which provides automatic adjustment.

If the net earnings, after making this allowance for depreciation, and after providing all expenses of operation including ordinary repairs, amount to as much as twice the interest charges upon the bonds outstanding, it is probable that the bonds may be taken with safety.

Before finally determining the question, however, certain political factors must be taken into consideration. The relations of the company to the leaders of the dominant political party must be investigated. The likelihood of agitation looking toward a reduction of fares must be considered and the possibility of increase in taxes (if below the legal limit) must be weighed. The probable att.i.tude of the legislature on the question of renewing the franchises when they expire must be considered.

In general, it must be learned whether any real ground of contention exists between the company on the one hand and the public and its representatives on the other, because it is inevitable that the company will weaken its independence of position by too close a connection with politics, and that the physical property will suffer if there is any lack of uninterrupted attention to it.

Finally one other thing should be investigated--the amount of the accident account and its proportion to the net earnings of the company.

On small lines a single case of heavy damages will sometimes make serious inroads upon the earnings.

The foregoing is a summary, necessarily brief and imperfect, but true in its essential outlines, of the main points which should be considered in judging the safety of street-railway bonds. The question remains, how far does the average street-railway company satisfy these requirements?

Broadly speaking, street-railway bonds are not yet to be cla.s.sed in the first rank of investment securities. The troubles which have come to a head in the financial operations of the traction systems in New York and Chicago are typical of troubles which are likely to occur elsewhere from the same general causes--overcapitalization in the first place and insufficient allowance for depreciation in the second place. In both New York and Chicago the crisis was hastened by open and obvious overcapitalization, which is almost inevitable when many independent lines are merged into one system. The same trouble, however, is apt to occur in other traction systems where this evil appeared less flagrant at the outset.

The advantages of electricity over horsepower naturally led to the multiplication of electric street lines, as the system ten or fifteen years ago pa.s.sed beyond the experimental stage. As in all new enterprises, speculation ran ahead of the reality and financing built upon oversanguine calculations has too often had difficulty in squaring accounts when brought face to face with facts. In most of the calculations insufficient allowance was made for the wear and tear of service; in other words, for renewal of road and equipment. After a few years' test of earnings against expenses, it became evident that a proper allowance for depreciation of plant would show a heavy deficit in the income account. In most cases therefore no allowance or only a meager one was made. For a time this method of bookkeeping proved less disastrous than might have been expected owing to the rapid growth of population and business in American cities. It was possible in many cases to consider the enhanced value given to the franchise by growth of business as an offset to the depreciation of tracks and equipment. In so far also as the plant was kept up to a high degree of efficiency by charging the expense of repairs to operating expenses, the absence of a depreciation account was partially offset.

With the progress of recent years, however, a new factor has been entering into the problem which promises to make the situation still more serious for the traction systems. This new factor is the rise in prices and wages. Temporarily the influence of this factor may be checked by diminished business activity, but when normal conditions are restored, it will commence to act again upon the railways with acc.u.mulated effect.

In most cases a proposition to increase the standard street-railway fare above five cents as an offset to the increased operating expenses would be so revolutionary a proposal that it could hardly be carried through.

With the line of cost converging upon the line of receipts and with no proper allowance made for depreciation, the traction systems of the country seem to be facing a difficult problem. In the long run it can not be doubted that the problem will be met and solved in a way to afford justice alike to the public who use the cars and to the capitalists who have made street traction on a large scale possible, but in the meantime the investor who desires perfect safety should exercise great care and discrimination in his purchases of street-railway obligations.

II. _Rate of Income._ As a general rule, street-railway bonds in common with the obligations of all public-service corporations sell upon about the same income basis as high-grade industrial bonds--that is to say, under normal conditions they return considerably more than railroad or munic.i.p.al bonds.

III. _Convertibility._ It is difficult to speak of the convertibility of public-utility bonds as a cla.s.s for the reason that they differ widely from one another in this respect. In general, it is certainly more difficult to dispose of public-utility bonds than railroad bonds. They do not possess sufficient convertibility to justify their purchase by any one who may need to realize quickly on his holdings.

IV. _Prospect of Appreciation in Value._ Public-utility bonds, except such issues as are convertible into stock, possess little prospect of appreciation in value. It was pointed out above that depreciation is not properly allowed for, and it is very difficult for the securities to advance in the face of this obstacle.

V. _Stability of Market Price._ The bonds of public-service corporations are relatively more stable than railroad bonds because their earnings are not subject to the fluctations which occur in railroad properties between years of prosperity and years of depression. At the same time, it should be pointed out that their stability of price is largely fict.i.tious, owing to the comparative inactivity of the issues. In other words, while the quotation may be maintained, it is usually difficult to sell any large quant.i.ty of a public-service corporation's bonds in a period of financial disturbance, while railroad bonds are more easily liquidated even if at a sacrifice.

The question remains, do public-utility bonds afford a desirable security for the investment of a business surplus and of private funds?

In regard to the former, it may be said at once that public-utility bonds do not meet the necessary conditions. The security is too doubtful, the convertibility is too small, and the stability of price too uncertain.

For private investment the case is somewhat different. Keeping in mind the desirability of diversifying investments and admitting the attractiveness of investing in a cla.s.s of property whose earnings are comparatively stable, it seems clear that public-utility bonds can not be dismissed without consideration. When a company is found whose property is substantially equal in real value to its bonded debt, whose allowance for depreciation is ample, whose franchises are satisfactory, whose earning capacity is large, and whose management is capable and upright, the investor is justified in giving careful consideration to its issues. Unless all these points are found to be satisfactory, however, the investor should content himself with some other form of security. For some years to come it is to be feared that many of our public-service corporations will suffer from the war of discordant elements--disregard of the rights of the public on the part of the management and socialistic agitation for control on the part of the community. Until these warring factions are reconciled and the questions at issue adjusted with fairness to the security-holders and the public, the investor should be most prudent in his purchases of public-utility obligations.